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The June Bug has a $340,000 bond issue outstanding. These bonds have a coupon rate of 6.25%, pay interest semiannually, and sell at 101.2% of face value. The tax rate is 35%. What is the amount of the annual interest tax shield?

-$21,505.00
-$119,000.00
-$5,311.22
-$7,437.50
-$21,250.00

User Indragie
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1 Answer

2 votes

Final answer:

The annual interest tax shield for the June Bug company is $7,437.50, calculated as 35% of the annual interest payment of $21,250. Therefore correct option is D

Step-by-step explanation:

The amount of the annual interest tax shield for the June Bug company can be calculated based on the given bond issue. The bond has a coupon rate of 6.25%, meaning that it pays 6.25% of the face value in interest per year. Since the face value is $340,000, the annual interest payment is 0.0625 × $340,000 = $21,250. The bonds are sold at 101.2% but that does not affect the coupon payments.

The tax shield is the reduction in taxes due to the interest payments being tax-deductible. With a tax rate of 35%, the tax shield is calculated as 0.35 × $21,250 = $7,437.50.

The yield or total return on a bond is the sum of interest payments and any capital gains. The capital gains or losses are realized if the bond is sold before maturity at a price different from its face value. This is influenced by the change in market interest rates:

  • When interest rates rise, bonds previously issued at lower interest rates will sell for less than face value.
  • Conversely, when interest rates fall, bonds previously issued at higher interest rates will sell for more than face value.

User Vmishra
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